When a group of my friends were planning an Easter trip to the USA, I wanted to try out Red Lobster. I’m a huge sucker for buffets and the endless shrimp offering was something that I was eager to take on as a new dietary challenge. Funnily enough, this was also one of the reasons cited for Red Lobster’s financial distress. Another reason was private equity.
According to this New York Times article, a new private-equity firm backer bought Red Lobster for $2.1 billion, before selling off the real estate under the restaurants for $1.5 billion. This resulted in Red Lobster restaurants having to pay rent since the land no longer belonged to them. The article also touches on poor management decisions on the part of both the original private equity firm, as well as the subsequent owners.
Private equity has been fingered for the collapse of multiple businesses aside from Red Lobster: Toys ‘R’ Us, Friendly’s, Morrisons Supermarket. They are dubbed “predatory” and the latest Wall Street scourge on Main Street. However, I think many of the criticisms are overplayed with accusations of terrifying jargon: “Asset-stripping” and “piling on debt”, against a industry that has made many financiers within it wealthy and hence become a lightning rod for criticism.
The Criticisms of Private Equity
Private equity (PE) has long been portrayed as the villain of the financial world. To the layperson disenchanted with capitalism, private equity firms are seen as predators: they buy companies, strip them for parts, load them with debt, and leave behind bankrupt shells. While some criticisms of the industry are valid, much of the narrative around private equity is oversimplified and fails to consider the nuances of its operations. Some criticisms are:
1.Bankruptcy RiskCritics often point to higher bankruptcy rates among PE-controlled companies. Moody’s found that PE-backed companies defaulted at twice the rate of those that are not. While this is statistically true, it may be due to self-selection. Private equity firms frequently acquire struggling businesses, aiming to turn them around. The higher risk of failure reflects the challenging nature of these acquisitions, not necessarily mismanagement by the PE firm.
2. Debt Accumulation
A common accusation is that PE firms pay themselves dividends funded by loans, leaving lenders to absorb losses when the company goes bankrupt. While this happens in some cases where the private equity firms mess up, it’s hard to imagine banks consistently lending recklessly to firms that force their portfolio companies into bankruptcy and result in a bad loan. Such practices would eventually damage the firms’ reputations and limit their ability to secure financing. Private equity firms can’t just conjure up debt and walk away with the proceeds and let the debt be defaulted on. Someone has to provide those bags of money, and the management of banks have their own shareholders to answer to.
3. Layoffs and Asset Stripping
Yes, private equity often reduces headcount. However, this typically targets inefficiencies within the company. Redundancies may arise from prior owners’ reluctance to make hard decisions, and trimming excess headcount is often necessary to ensure a company’s long-term survival. Ultimately, private equity increases the focus and pressure to turn a profit, which can lead to decisions that appear heartless. Still,
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Private Equity Vultures
I view private equity firms as vultures – though not in the negative light many paint them in. Vultures clean up the ecosystem and break-down carcasses for easier decomposition. Similarly, private equity firms speed up the deaths of companies that are no longer viable. While it is distressing for workers to suddenly lose their livelihoods when companies are shuttered, capital and other resources locked up in a failing business would be more efficiently allocated to other purposes. Furthermore, unlike vultures, private equity firms aim to revitalise businesses by bringing in experienced management when a turnaround is feasible—an approach that is often more profitable than asset liquidation. These turnarounds can yield significant benefits for society.
Risks of Private Equity
The failure of PE-backed companies is unlikely to be deliberate, as it harms the investors themselves. We see from the Red Lobster example that although the land was sold for $1.5 billion, the eventual value of the rest of the company fell to $375 million when it changed hands for the third time. Given the original purchase price of $2.1 billion, someone – whether the private equity firm or the corporate acquirer – lost about $500 million. One potential criticism that could be valid is that private equity firms are over-extended into companies they know little about. The very initial targets of private equity firms, inefficient conglomerates, were broken up and saw the sum of the parts worth more than the whole. However, private equity can quickly resemble holding companies like those they sought to break up.
This can lead to cost-cutting moves that appear wonderful on paper, but have insidious long-term effects in weakening the business. Given the long-term value destruction, I doubt private equity firms would choose to do this if they knew what the long-term effects would be. Having worked with some investors, I have seen how hubris on knowing how to turnaround the company contradicted what company employees were saying. Dismissing the concerns of employees as vested interests seeking to retain their department’s spending, the investors forced cuts to the budget that the workers argued would cripple their ability to carry out their work. While I never found out who was right, perhaps the Masters of the Universe may not truly have universal knowledge about how to run a company.
After all, their sprawling holdings and controlling stakes in companies could represent a concentration of market share in the hands of a single decision-making firm. This could facilitate price collusion among portfolio companies in the same industry. Standard Oil was broken up in 1911 for such anti-competitive practices, where subsidiaries of the company were engaged in price-fixing despite efforts to disguise the business relationships between subsidiary and parent. There are long-overdue moves by the Biden administration to look into anti-competitive behaviour by private equity firms.
Why the bad image persists
It’s understandable if the private equity industry has an image problem. Turnaround stories by private equity-controlled companies like Lululemon hardly make for spectacular headlines as bankruptcy does. Meanwhile, the work of private equity firms is mostly B2B, unless there are major layoffs where the public is affected. There is no reason for the layperson to know the names of these firms behind popular retail brands. Nor do private equity firms have a need to invest in improving their reputation – with the exception of avoiding stifling regulations, there is no profit motive to having a good relationship with the layperson.
Furthermore, private equity has been hugely successful tapping on an asset class that was under explored in the 1980s. The success has culminated in fantastic wealth for a few – which unlike the stock market does not spread the benefits with the public. There have been moves to democratise private equity. While attractive, I would argue that private equity often remains private for a reason. The critical difference lies in the fact that companies that choose to go public are subject to higher disclosure requirements. As such, private equity platforms offering investment opportunities to retail investors will either have to subject the companies they invest in to such disclosure rules, or that investors will have to be comfortable with the information asymmetry. The latter is particularly dangerous, as this opens up retail investors to fraud by unscrupulous founders seeking to rip-off investors. There is a reason why Elizabeth Holmes could only defraud those who could afford it – and frankly should have had the capability to do proper due diligence on Theranos.
That, combined with the public-facing negative news such as layoffs and lowered quality, makes private equity firms an easy target for media and politicians seeking to simplify the factors behind why people are suffering.
Why this is important
Private equity does pose some potential risks to the stability and fair functioning of the market, given an active management strategy as well as large pools of assets. However, a balanced assessment of their impact on society should be considered instead of a blanket negative impression. It’s in their interests if the business they buy continues to thrive so they can enjoy a higher rate of return. That said, they will extract and liquidate a business that is deemed unviable, instead of allowing it to chug along in a zombified way through a slow and long death. If private equity is a career path you are seeking, it’s important to understand both the fact that your job is not an anti-social as may appear and the pitfalls hubris can lead you towards.
For the rest of us who don’t seek to join a private equity fund, it’s important to avoid pinning the blame conveniently on private equity firms. Yes, there’s not need to be sympathetic for them – private equity professionals earn enough to take the brickbats without my tears. However, blaming private equity distracts from implementing real solutions and holding accountable the management who caused the business to struggle in the first place.Red Lobster might have seen the nail in the coffin hammered in by private equity, but it was already a struggling chain take out by the pandemic, as explained in the above-linked NYT article. We should also be pushing for harder regulations to curtail unfair behaviour, such as using debt to discharge their portfolio company’s of pension benefits. We need targeted criticism and concrete policy ideas rather than praying for the demise of an industry that is an important player in the business ecosystem.
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